2 Ways To Engineer Startup Luck
(This is part 2 of startup luck series. Go to part 1).
It is clear that startups increasingly depend on luck.
However, almost all startup advice in Silicon Valley teaches you how to maximize your skills. There are tons of free resources that teach you how to acquire, refining and leverage your entrepreneurial skill.
Most of the advice is colored by “survivorship bias”. And, almost all of it comes from people who have portfolio diversification, management fees, or jobs at big companies which were once startups. This means the people who drive the conversation are at a different place in their lives than you, the Founder.
As a Founder, you need to know how to “engineer” your luck. (This may sound nonsensical because if something can be engineered, is it really even luck? I urge you to read on).
It’s common knowledge that every startup is an experiment with a very low probability of success. By definition, each individual experiment will very likely fail. But if you are a VC with a large enough fund size and reputation, you can diversify your risk and play the odds by betting on power laws.
But as a founder, how can you overcome these seemingly insurmountable odds and acheive success?
There are two ways to engineer your own luck. And both of them require you to harness optionality.
Optionality: The key to startup success
“Optionality is the property of asymmetric upside (preferably unlimited) with correspondingly limited downside (preferably tiny)” — Nassim Taleb
The key here is “asymmetric”, meaning your small investment of time and resources could lead to a large potential outcome, if certain conditions are met. The key learning point here for founders is the emphasis on “asymmetric”, meaning all your actions and efforts should have the potential to produce a disproportionately favorable result, aka a venture investable startup.
1. The Studio Model: Accumulating optionality over time
Like a movie studio, a venture studio (or startup studio) is a laboratory that is designed to rapidly come up with ideas, iterate and test for product market fit, and spin out those that find product market fit to scale.
To model this, think of a startup as a Bernoulli trial with two possible outcomes, “success” and “failure”. If it results in an exit that financially rewards the founders and investors, it is a success and any other outcome is a failure. However, there is a catch.
Probability theory says that if the experiments are truly independent of each other and the odds of success are fixed and randomly determined for each trial, the only reliable way to succeed is to try enough number of times.
When you try discrete experiments enough number of times, the discrete probability events will approximate a continuous probability process called a “Poisson process”, and these independent events start occuring at a constant average rate. Then, the likelihood of financial success can be represented by a nice little probability density function which is easy to model and build intuitions and investment strategies around.
The “Bernoulli Trap”
The graph above looks deceptively good because it makes us think that if we try enough number of times, we get to that one success that amortizes all our failures.
But, there is a catch. Because you live in human timescale and your entrepreneurial lifespan is limited, you can’t do a 100 startups serially to get to the one success that amortizes the cost of all our failures because your
This is a version of the “ergodicity problem” where you, in your limited entrepreneurial lifespan, cannot access all the other parallel realities simultaneously, to achieve the “average” success. Which frequently means that as an entrepreneur, you run out of risk tolerance, time, and money and settle for a “safe” job or “ruin” before making it through the required number of startup experiments. I call this the “Bernoulli Trap”. It is a problem because we can’t all get to be Tom Cruise in Edge of Tomorrow.
How to Escape the Bernoulli trap
If you think it through, you will see that the key to breaking out of this Bernoulli trap is to make the experiments non-independent.
If all your startup experiments remain independant with random and rougly equal odds of success, your odds of success will continue to remain poor. The bane of serial entrepreneurs is “Domain switching”.
For example, if you start a SAAS company, an ecommerce company and a self driving car company in quicl succession, your subsequent startups do not benefit much from your earlier experience, and the odds of success remain largely independent and roughly the same.
However, if you do a series of digital health startups, the accumulated wisdom, network and experience from all prior experiments compound over time and improve your odds of success with each iteration.
The key to this process is selecting your focus on a broad market, ideally one which is growing fast and will do so for a long time. If you pick your criteria right, you can get significantly better with each experiment and shortcut the path to a successful outcome.
To do this, you need to focus on a specific sector or domain. Each failed experiment compounds your learnings over time either in understanding a segment of users’ desires, behaviors and channels, partnerships, relationships with key opinion leaders and so on. Over long periods, knowledge, relationships and expertise add up to disproportionate advantages.
By taking a portfolio approach, you move your odds of success away from one idea succeeding to one market succeeding.
This “coupling” of experiments allows you to escape the “Bernoulli Trap” .
A well built venture studio indexes it’s success to that of the underlying sector.
Venture Studio reduces transaction costs:
Instead of building a company, team, investor relationships and funding for each startup, a studio spreads all costs over many “projects”. Moreover, you don’t need to go back to your investors and sell them on your “pivot”, everytime you change direction. You lower transaction costs and iteration time by defining the process at the outset.
“The venture studio minimizes the time and resource costs of each exposure, while maximizing the number of exposures (unbounded upside with bounded downside).”
Another advantage of picking a sector is that you create your own proprietary data and tools which get better over time and they can’t easily be replicated by challengers.
The Studio increases option value over time
By having resources to quickly and cheaply experiment to find product market fit, the venture studio gives founders and investors optionality whose premium price gets cheaper over time. If a breakout product is found, it could be spun off but with 20–25% equity ownership retained by the studio for funding future ventures, creating an evergreen fund structure.
2. Founderpool: A portfolio approach to startups
Can a generic “insurance like” arrangement reduce startup risk for founders?
The principle behind insurance is that events that could be catastrophic for individuals can be pooled together to minimize risk.
If a startup is really a “risk”, you can buy insurance for it. Meaning, aggregating many measurable risks can result in a predictably profitable outcome for the “pool” if the portfolio is constructed well and premiums are priced appropriately. This is the principle of insurance.
Founderpool brings the concept of “pooled risk” to startups.
However, because startups don’t live in the domain of risk but in uncertainty (Frank H Knight, Risk, Profit and Uncertainty, Part III, Chapter VII: The Meaning of Risk and Uncertainty) a portfolio diversification approach should not make sense.
So why do I believe that “Founderpools” work?
“Great founders recognize other great founders”
They seem to have an uncanny ability to identify other great founders and companies. They seem to be better at it than VCs, angel investors and anyone else. We can speculate as to the reasons why.
It may be the experience of being in the trenches right now, in the same industry. It may also be a lack of all the perverted incentives that come from being a professional money manager allows them to think clearer. Or it may come from the insight that comes with knowing what they lack and seeing those traits and attributes in other founders.
Whatever the case, this is the principle behind Sequoia’s scout program and Angellist’s spearhead. This may also be the reason for “Mafias” such as PayPal, YCombinator exist.
How does FounderPool work?
A founder pool is an equity swap vehicle. When two or more founders from different startups join a pool, they allocate equity in their startup to the pool and get a proportionate amount of shares in the pool. This proportion is determined by the price of equity at the last funding round. For example, if Startup A raised it’s last round of $1M at $9M premoney and startup B raised $500k at $5M valuation. When founders of both companies agree to join a founder pool, 1% of each startup goes into the pool, and the ownership is represented as follows:
Pool consists of 100 shares P. The pool consists of 1% of A shares, valued at $100k and 1% of B shares valued at $50k.
Each share of P has an aggregate value of $1500.
Founder A gets 66.66 P and Founder B gets 33.34 P, worth the same amount they contributed ($100K to A and $50k to B).
If a founder of startup C joins the pool at the request of founders A and B, he proportionately allocates his equity into the pool and gets Pool shares P in return.
As you can see, the pool gets more and more diverse over time as more and more founders get accepted into it. (The model is much more complex than this due to legal, incentive and other issues. Please see Founderpools.com for more details).
Combining The Venture Studio with Founderpool:
A studio model can be combined with the “Pool” model, as both share common objectives.
A fund could raise capital to invest in a market or sector and dedicate part of the funding to a Venture studio for incubating internal projects, while also investing in startups outside the studio.
Here, all startups that get funded also get to contribute a % of their equity to owning the fund’s studio protfolio. That way, not only do they get capital, but also get to plug into a community of founders with shared market insight, relationships and expertise.
Essentially, the fund becomes a community of founders that are incentivized to support each other, but also have a downsize protection by default.
For an entrepreneur looking to raise capital, money from such a fund would be a massive value add compared to a run of the mill VC fund.
Because funds live or die by deal flow, and given that “differentiators” are hard to come by these days, the first few funds to follow this hybrid model will have a massive leg up over others in the sector.
(To see how Founderpool works, and how to get into a FounderPool, check out Founderpools.com .)
